Jubak's Journal
Level 3: When Business Plans Go Bust
By Jim Jubak
Senior Markets Editor, MSN MoneyCentral
8/3/01 8:20 AM ET
URL: thestreet.com
The investing landscape is littered with the smoldering pages of discarded business plans. Each one is a reminder of how fast the heady days of 1999, when revenue growth for new technology companies promised to go on forever, have turned into the "where's the bottom?" days of 2001. The spreadsheets, the descriptions of future markets, the graphs of potential markets in each one of these plans is a record of the dreams of CEOs and investors in the not-so-long-ago past.
But old business plans aren't just historical relics ready for museum display. They're descriptions of how much money a company once thought it could make for investors and how much money it would need from them to realize that goal. Because those two issues -- how much profit a company can turn on an investor's dollar and how big a piece of the company the investor gets for that dollar -- ultimately determine the value of a stock, you can think of a business plan as a description of how profitable an investment will be if everything goes according to plan.
Hardly anything ever does, of course. And by comparing the old plan with the current version, investors can get a sense of just how far off course a company may have wandered. Sometimes, all that a company has done between versions is tweak a profit margin or two. In other cases, it's clear that the original vision just doesn't make business sense any more. Circumstances have changed so much that the original plan is simply busted.
In my July 20 column, I wrote that Level 3 (LVLT:Nasdaq) fell into the "busted plan" camp. I don't think the company is unique in this -- circumstances have changed radically for the entire telecommunications sector. Heck, growth has collapsed for the entire sector. I could make the same judgment about the business plans at WorldCom (WCOM:Nasdaq), XO Communications(XOXO:Nasdaq) or McLeodUSA(MCLD:Nasdaq). But I also went on to say that I thought the business plan at Level 3 was so broken that I was thinking about dropping it from the very long-term Fantastic Future 50 portfolio.
That produced a wave of protest. First, some readers argued that the plan wasn't broken at all -- Level 3, they believed, was still on something close to the original schedule. Second, other readers argued that, while the original plan was busted, Level 3 had the ability to fix the problems or come up with a new plan that would still produce substantial profits for investors.
I think the first of these two opinions is just plain wrong, and I'll show you why in this column. The second, however, has some merit -- enough to keep Level 3 in the Future 50 portfolio while we see how the company responds to the new telecommunications market. I'll explain that conclusion, too, in what follows.
Level 3's Plan Is Busted
Let's go back just about a year to July 2000. The Nasdaq bubble had popped, but very few investors or analysts realized that the telecom sector was about to collapse. Level 3 seemed to be in great shape. The company was building its network of 20,750 miles of long-haul fiber to allow rapid and relatively inexpensive future upgrades.
Most long-haul networks built to date or then under construction laid down just a single conduit for optical fiber. Level 3 had buried 12 conduits along its route. When traffic grew in the future, the company could go back and string optical fiber in the empty conduits without having to dig a new trench and lay new conduit. By combining the best of current optical technology with this easily upgradeable architecture, Level 3 hoped to be the low-cost long-haul provider for the foreseeable future. Certainly, looking at its plans, it was hard to see how companies with older networks, such as AT&T(T:NYSE), were going to compete.
Building an upgradeable, state-of-the-art 20,000-mile network was expensive, but Level 3's plan had that angle covered, it seemed then, thanks to Wall Street's almost insatiable appetite for telecom debt. The company had sold more than $7 billion in debt to help build up $8 billion in cash on its balance sheet. With another $900 million in a credit line, plus shares in several telecommunications start-ups worth $1.2 billion at then-market prices, Level 3 had enough cash to carry it through to EBITDA (earnings before interest payments, taxes, depreciation and amortization) break-even in 2002. It was, in Wall Street terms, fully funded.
What a difference a year makes. Total cash revenue, which was supposed to come in at better than $3 billion in 2002, now looks as if it will fall closer to $2 billion. Revenue, which was supposed to grow by about 65% in 2002 from the 2001 level, now is likely to remain essentially flat in 2002. The operating loss for 2003 is likely to be more than $1 billion above earlier projections.
But it's the change in the company's financial position that makes me call the plan busted. At the end of the second quarter of 2001, Level 3 had $3.2 billion in cash instead of $8 billion, and access to a credit line of $650 million instead of $900 million. That's enough cash to get the company to the middle of 2003, but it leaves it with a funding gap of somewhere between $1 billion and $1.5 billion. You don't need to look any further to understand recent share-price levels near $4.50. Filling that funding gap is going to require Level 3 to raise more money, which will dilute the percentage of the company that current equity holders actually own. That is, if the company can raise the funds at all.
Level 3 Can "Fix" Its Plan -- at a Big Cost to Shareholders
I think Level 3 will succeed in closing its funding gap one way or another. On July 26, for example, the company announced that it was in negotiations with the investors who hold its senior debt to exchange that debt for common stock. Such an exchange would cut Level 3's interest payments and bring the company closer to being fully funded. And with the bonds trading at just 57 cents on the dollar, swapping equity for debt isn't a bad financial move, either.
But it won't make current shareholders any richer in the short run. That's because the new shares that go to current bondholders would dilute the ownership stake of current common shareholders. On the day after the news, Level 3 shares fell about 11%, while the company's senior bonds climbed about 10% in value.
Level 3 has other ways to reduce its funding gap, too. It has been cutting costs over the past quarter and reducing its capital-spending budget -- not good news for telecom gearmakers, by the way.
None of this will reignite revenue growth -- there are simply too many long-haul telecom companies in the market. According to Robertson Stephens, there are 14 nationwide operators of intercity networks in the U.S. In the 1980s, there were just four U.S. national fiber networks. The first of the "excess" long-haul operators have just started to file for bankruptcy. Judging from the shakeout in the competitive local exchange carrier (CLEC) market, which started in May 2000 and is now about halfway complete, the process of reducing the number of players in the long-haul market and eliminating extra capacity could take another 24 months.
All this means that I certainly wouldn't rush to buy Level 3 common stock right now, even though it's priced as if the company is going out of business. Filling the funding gap will likely dilute current equity holders in the short term, even from this price. (Level 3 bonds, however, are an entirely different story. The very factors that work against Level 3 stock work in favor of Level 3 bonds.) And the shakeout in the long-haul telecom market is really just beginning.
But for the truly long-term investor -- and remember, the Future 50 portfolio envisions a holding period of 10 years or more -- Level 3 deserves watching. The original strengths of its network architecture do give the company a substantial cost advantage, and the company could come out of this sector collapse as a solid independent company. Although, it's much more likely that Level 3 will be acquired by another company because of the strength of its network.
Just remember that we're not talking about a turnaround in the long-haul telecommunications market next month. We're talking about a year, maybe two. Anything that you can do to limit the time you sit in the stock while it's dead money will increase your returns. If you don't own shares now, I'd certainly wait for some signs that the funding gap has been closed for good and the markets have taken their last bite out of equity holders' hides before buying.
OK, that all sounds pretty dire. But I'm still keeping Level 3 in the Future 50 portfolio. Does that mean there isn't any telecom stock that I won't keep on the list if the time horizon is long enough? Well, no. There are stocks in this sector that carry much higher risk to equity investors than Level 3.
In my next column, I'll write about what I call "ownership structure" risk. That's the possibility that insiders will snap up currently depressed common shares and take the company private. In that case, these insiders will reap almost all the reward from buying underpriced assets and then selling them off when the market recovers. And patient, long-term equity investors will get almost nothing for their time and pain.
It's a risk that's especially high in telecommunications right now -- but it's something to watch out for across the technology sector.
New Developments on Past Columns
Selling Strategies for Buy-and-Hold Investors: On Aug. 1, the Federal Trade Commission cleared PepsiCo's(PEP:NYSE) acquisition of Quaker Oats(OAT:NYSE). With the last regulatory hurdle removed, the companies said they expected to complete the transaction within a few days. Acquiring Quaker's Gatorade brand, which generates about $2.1 billion in sales, is the point of this deal. PepsiCo figures that it can use its distribution clout to expand sales of the No. 1 sports drink more rapidly than Quaker could. The downside of the deal is that PepsiCo now owns all the Quaker food and cereal brands -- and can't get rid of them until the mandatory two-year holding period elapses. PepsiCo will be challenged to manage these businesses so that they bring a good price on the market in the future while not allowing them to divert the company from its core in soft drinks and salted snacks. But I think management is up to it.
Who Wins When Life Goes Digital? On July 31, Wind River Systems(WIND:Nasdaq) warned that second-quarter earnings and revenue wouldn't meet projections. For the period that ends in July, the company now expects revenue of $79 million to $82 million, about 15% below the low end of previous projections and a decline from first-quarter revenue of more than 25%. Third-quarter revenue, Wind River management said, should be flat or slightly above second-quarter levels.
The problem seems to lie with the company's communication and storage infrastructure markets, which make up about 50% of revenue. Wind River's customers are cutting their research and development budgets, and that means less spending on Wind River's tools for developing new embedded chips and fewer new products using Wind River's real-time operating system. On the upside, Wind River has added new business during the quarter at Sony(SNE:NYSE ADR), Alcatel(ALA:NYSE ADR) and Motorola(MOT:NYSE), and management is continuing to cut costs. Total operating expenses are likely to be 8% to 10% lower in the second quarter when the company finally reports earnings.
The long-term picture for Wind River remains bright, in my opinion, because there are no signs of erosion in the company's 75% market share for embedded real-time operating systems. But with the slowdown in the communications sector now likely to stretch well into 2002, as of Aug. 3, I'm cutting my target price for Wind River to $25 by June 2002 from the recent target of $45 by March 2002.
Three Baby Bells Emerge Winners -- and One's a Buy: On July 30, Verizon (VZ:NYSE) reported earnings of 77 cents a share for the second quarter, meeting Wall Street expectations. But the company lowered its projections for the rest of 2001 to reflect continuing weakness in the economy. In the quarter, the number of total access lines declined by 0.4% from the same quarter in 2000 as businesses reduced their headcounts and cut back on the number of lines they need. The company now expects revenue growth of 5% to 6% for the full year. That's down from the 6% to 8% that the company had projected earlier.
However, not all the news was bad. The company's data business continued to roar ahead, with the number of data circuits in service increasing by 53%. I added Verizon to Jubak's Picks largely on expectations that the company would be able to grow its long-distance business at faster-than-market rates as it entered new markets. There was certainly good news on that front in the quarter: The company added 800,000 new long-distance customers in the period and continues to show that it can easily gain 30% market share after state regulators approve the company's entry into their market. For example, this quarter the company took 10% of the long-distance market in Massachusetts in the two months after it received approval to sell long-distance service in the state.
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At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Wind River Systems.
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